Proposed guidelines from a group of federal agencies over balance sheet exposure to commercial real estate has credit default swaps specialists considering new opportunities to structure collateralized debt obligations. The guidelines, introduced several months ago (REFI 5/29) would help small banks reduce risk synthetically, Wall Street firms are looking to customize structures into larger, tranched transactions.
The Office of the Comptroller of the Currency, the Federal Reserve, the Federal Deposit Insurance Corporation and Office of Thrift Supervision are especially concerned with geographic concentrations. They are expected to issue their final guidelines by the end of summer.
Wall Street firms have already structured deals in which one community bank acquires exposure to a geographically diverse pool of commercial loans from other banks across the country. But some firms are looking at setting up larger CDOs with many mezzanine slices that would offer more opportunities for banks to both buy and sell protection on their portfolios via credit default swaps. Rating agency officials said that no deals have been formally presented for review but expect the major swap dealers to tap this area of business.
The deal would likely have a community bank buying protection on a mezzanine slice of its commercial mortgage portfolio. According to a recent Nomura report, such protection might be tailored to cover losses that exceed 1.5% of the original balance of the loans up to a maximum of 5%. If the bank's commercial loan portfolio is $1 billion, the swap might cover losses from $15 million to $50 million via a CDS with an attachment point of 1.5% and a detachment point of 5%, the report noted. The idea is that a CDO's super-senior tranches could be marketed to other investors that have lower yield targets and risk tolerances, said Mark Adelson, analyst at Nomura, who penned the report.
The guidelines propose to limit areas such as construction and land development lending and ensure that lenders do not exceed specific thresholds for risk-based capital. The guidelines, which are currently out for comment, could be implemented as soon as the third quarter. Smaller banks and large national lenders have filed hundreds of comments on the guidelines, objecting to the thresholds proposed by the agencies. The guidelines were expected to be introduced earlier but were delayed due to discussions between the agencies and banks. It is too early to determine how the introduction of derivatives will affect the analysis of the guidelines.
